In Part 1, we discussed some rookie mistakes we've seen businesses make while creating financial forecasts. New businesses are especially prone to making errors when they create forecasts for the first time. Apart from building business forecasts that are error-free, how do you also make them robust and reliable? We explore a few basic principles for good business forecasts in this post.
Start from scratch
Last year's forecast is a helpful guide, but it's not a basis for this year's forecast. Consider the macro aspects – the economy, your sector, your competitors, foreign exchange and monetary policies. Is someone developing a competing product that launches next year? What if all your customers are overseas, you invoice customers in Euros and the rupee is expected to strengthen over the next six months?
If yours is a stable company in a stable sector, you might just need to check that no major changes have occurred. If you're in a volatile sector, you'll need to do a full analysis of all the issues that could affect the business forecasts.
This is a great way to approach the forecasting process and to inspire trust among the people receiving your forecasts. No one expects a single forecast to be 100% accurate, but creating 2-3 scenarios (let's say base case, mid-growth and high-growth) is very helpful.
Not only does this display a solid understanding of the positives and negatives of the business, it also quantifies the upside and downside – this is critical. Make sure you model all aspects of each scenario – don't miss out the extra capex and borrowings that you'd need in the high-growth scenario! Remember: if the high-growth scenario looks too good to be true, it probably is.
Step away from the forecasts
Being close to the forecasting process means you bring your own biases to it. Get some distance and think as an outsider – how confident are you that targets will be met? Can you really scale your revenues without hiring new people? Are you sure your customers are this sticky?
This step is critical and even more so for entrepreneurs. Take a break and re-visit your forecasts after a week. Maybe show them to an actual outsider. Think of every thing that can go wrong and model a "worst case" to see how far it lands from your "base case". The forecasting process is great because every now and then you'll see a risk you didn't see before, and once you've seen it, you can start preparing against it.
Remember first principles
Either through oversight or ignorance, professionals can miss basic principles when they build business forecasts. How to treat non-recurring items, converting profits to cash flows for the future, dealing with balance sheet changes and their impact on the cash flow, and the difference between a GAAP cash flow and a cash flow forecast are the most common ones.
Ask for help
The forecasting process usually requires inputs from every part of the company. Take their ideas and numbers, apply your own judgement and draw your conclusions. View each portion in a silo and then as part of the whole. Don't shy away from asking people to re-do their estimates if you see inconsistencies.
Finally, if the task seems too burdensome or time-consuming, outsource. A good expert will not just do the job quicker and with a higher level of accuracy, they will also bring their own insights to your business and strategy, freeing you up to focus on other things.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.